I am a Burmese exile taking a near-permanent refuge in New York and Sydney. Here are my essays about Burma and anything else I feel like writing about. And posting the articles I like from selected sites. Bridging Burma to the world this Blog is more of a Politically-Oriented Literary Blog than a Plain News Blog or a Sophisticated Thoughts Blog.

Friday, August 28, 2015

How Do Asset Bubbles Cause Recessions?

Asset bubbles shoulder blame for some
of the most devastating recessions ever faced by the United States. The stock
market bubble of the 1920s, the dot-com bubble of the 1990s and the real estate
bubble of the 2000s were asset bubbles followed by sharp economic downturns.

Asset bubbles are especially
devastating for individuals and businesses who invest too late, meaning shortly
before the bubble bursts. This unfortunate timing erodes net worth and causes
businesses to fail, touching off a cascade effect of higher unemployment, lower
productivity and financial panic.

HOW ASSET BUBBLES WORK

An asset bubble occurs when the price
of an asset, such as stocks, bonds, real estate or commodities, rises at a
rapid pace without underlying fundamentals, such as equally fast-rising demand,
to justify the price spike.

Like a snowball, an asset bubble feeds on itself. When an asset price
begins rising at a rate appreciably higher than the broader market,
opportunistic investors and speculators jump in and bid the price up even more.
This leads to further speculation and further price increases not supported by
market fundamentals.

The real trouble starts when the asset
bubble picks up so much speed that everyday people, many of whom have
little-to-no investing experience, take notice and decide they can profit from
rising prices. The resulting flood of investment dollars into the asset pushes
the price up to even more inflated and unsustainable levels.

Eventually, one of several triggers
causes the asset bubble to burst. This sends prices falling precipitously and
wreaks havoc for latecomers to the game, most of whom lose a large percentage
of their investments. A common trigger is demand becomes exhausted. The
resulting downward shift puts downward pressure on prices.

Another possible trigger is a slowdown
in another area of the economy. Without economic strength, fewer people have
the disposable income to invest in high-priced assets. This also shifts the
demand curve downward and sends prices plummeting.

HISTORICAL EXAMPLES OF ASSET BUBBLES

The biggest asset bubbles in recent
history have been followed by deep recessions. The inverse is equally true.
Since the early 20th century, the largest and most high-profile economic crises
in the U.S. have been preceded by asset bubbles.

While the correlation between asset
bubbles and recessions is irrefutable, economists debate the strength of the
cause-and-effect relationship. Universal agreement exists, however, that the
bursting of an asset bubble has played at least some role in each of the
following economic recessions.

THE 1920S STOCK MARKET BUBBLE/THE GREAT DEPRESSION

The 1920s began with a deep but short
recession that gave way to a prolonged period of economic expansion. Lavish
wealth, the kind depicted in F. Scott Fitzgerald's "The Great
Gatsby," became an American mainstay during the Roaring Twenties.

The bubble started when the government, in response to the recession,
eased credit requirements and lowered interest rates, hoping to spur borrowing,
increase the money supply and stimulate the economy.

It worked, but too well. Consumers and
businesses began taking on more debt than ever. By the middle of the decade,
there was an additional $500 million in circulation compared to five years
earlier. Stock prices soared as a result of the new money flowing through the
economy.

The excess of the 1920s was fun while
it lasted but far from sustainable. By 1929, cracks began to appear in the
facade. The problem was debt had fueled too much of the decade's extravagance.
The most prescient investors, the ones tuned in to the idea the good times were
about to end, began profit-taking. They locked in their gains, anticipating a
coming market decline.

Before too long, a massive sell-off
took hold. People and businesses began cashing out their investments so
quickly, the banks lacked the capital to give everyone their money. The rapidly
worsening situation culminated with the crash of 1929, which witnessed the
insolvency of several large banks due to bank runs.

The crash touched off The Great
Depression, still known as the worst economic crisis in modern American
history. While the official years of the Depression were from 1929 to 1939, the
economy did not regain footing on a long-term basis until World War II ended in
1945.

THE 1990S DOT-COM BUBBLE/EARLY 2000S RECESSION

In the year 1990, the words Internet,
Web and online did not even exist in the common lexicon. By 1999, they
dominated the economy. The Nasdaq index, which tracks mostly tech-based stocks,
hovered below 500 at the beginning of the 1990s. By the turn of the century, it
had soared past 5,000.

The Internet changed the way the world
lives and does business. Many solid, lasting companies launched during the
dot-com bubble, such as Google, Yahoo and Amazon. Dwarfing the number of these
companies, however, was the number of fly-by-night companies with no long-term
vision, no innovation and often no product at all.

Because investors were swept up in
dot-com mania, these companies still attracted millions of investment dollars,
many even managing to go public without ever having brought a product to
market.

A Nasdaq sell-off in March 2000 marked
the end of the dot-com bubble. The recession that followed was relatively
shallow for the broader economy but devastating for the tech industry. The Bay
Area in California, home to tech-heavy Silicon Valley, saw unemployment rates
reach their highest levels in decades.

THE 2000S REAL ESTATE BUBBLE/THE GREAT RECESSION

Many factors coalesced to produce the
2000s real estate bubble. The biggest were low interest rates and significantly
relaxed lending standards. As house fever spread like a drought-fueled
conflagration, lenders, particularly those in the high-risk arena known as
subprime, began competing with each other on who could relax standards the most
and attract the riskiest buyers.

One loan product that best embodies the level of insanity reached by
subprime lenders in the mid-2000s is the NI-NA-NE loan; no income, no assets
and no employment verification were required for approval.

For much of the 2000s, getting a
mortgage was easier than getting approved to rent an apartment. As a result,
demand for real estate surged. Real estate agents, builders, bankers and
mortgage brokers frolicked in the excess, making piles of money as easily as
the 1980s Masters of the Universe portrayed in Tom Wolfe's "Bonfire of the
Vanities."

As one might expect, a bubble fueled in
large part by the practice of loaning hundreds of thousands of dollars to
people unable to prove they had assets or even jobs was unsustainable. In
certain parts of the country, such as Florida and Las Vegas, home prices began
to tumble as early as 2006.

By 2008, the entire country was in full economic meltdown. Large banks,
including the storied Lehman Brothers, became insolvent, a result of tying up
too much money in securities backed by the aforementioned subprime mortgages.
Housing prices tumbled by more than 50% in some areas. As of 2015, the majority
of Americans feel the economy still has not fully recovered from the Great
Recession.